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Deficits are an important but incomplete metric

The budget debate will soon expand beyond the current short-term fight. Negotiations on appropriations funding for the remainder of FY11 continue, and a government shutdown on April 9th is quite possible. I will write about that battle as events dictate, but hope to focus most of my attention on the more important big fiscal picture.

The following discussion may seem a bit theoretical. I think it’s an important starting point.

Washington traditionally focuses its attention on the federal budget deficit, the difference between government spending and revenues. We need to expand our scope and think about two allocation decisions made in each year’s budget debate.

The first decision is how much of society’s resources we want to allocate to the federal government. For sixty years from 1950-2009 this number was surprisingly stable. Total federal government spending averaged about 20% of GDP. The other four-fifths was private sector spending by individuals, families, and private businesses, plus spending by State & local governments.

A better and more difficult analysis would compare the allocation of resources between the public and private sectors. Since Washington directly decides only how much the federal government will spend, we end up with federal government vs. everything else.

The second decision is the timing of how we want to allocate the financing of that government spending over time. How much of this year’s federal government spending should be financed through current taxes, and how much through future taxes? Over that same 60-year period, that 20% of federal spending was allocated 18-2. Federal taxes averaged about 18% of GDP, and budget deficits averaged about 2% of GDP.

(Data is from OMB’s historical tables, and these numbers don’t move by more than a couple tenths of a percentage point if you shift the historic windows by several years. It’s always 20-18-2.)

I therefore hope you will remember the following numbers, which pretty much define the big picture of federal budget policy for a 60-year period:

Washington policymakers allocated 20% of our economy to Federal government spending, leaving the other 80% for private spending by individuals, families, and businesses, along with State & local government spending.

That government spending of 20% of GDP was allocated 18-2: Elected officials taxed their citizens by 18% of GDP, and they borrowed the other 2%. That borrowing, plus the interest that accumulates on it, represents a burden on future taxpayers.

I write it this way: (80/20, 18/2).

At a macro level, those four numbers tell you a ton about federal budget policy, and they provide much more information than if you look only at the average budget deficit over that timeframe (2).

Most of Washington focuses only on the 2. The budget deficit is an incredibly important number in fiscal policy. It represents the tax burden this generation of policymakers is placing on future citizens. That’s a huge deal. These officials are making decisions to allocate the earnings of future taxpayers before those taxpayers earn it, before they can vote, and in some cases before they even exist.

At the same time, if we look only at the budget deficit, we miss the other macro decision. The budget deficit is a critical but incomplete measure of macro fiscal policy. At this level we need to consider two dimensions of each decision, not just one.

Let’s look at two examples.

Example 1: Two very different balanced budgets

Case A: The federal government spends 25% of GDP each year and collects the same in tax revenues. 75% of GDP is available for the private sector plus State & local government.

Case B: The federal government spends 20% of GDP each year and collects the same in tax revenues. 80% of GDP is available for the private sector plus State & local government.

In my notation, Case A is (75/25, 25/0), and Case B is (80/20, 20/0).

Both A and B are balanced budgets. In both cases current taxpayers are financing all of today’s government spending. No financing burden is being imposed on future taxpayers.

The traditional Washington deficit-only debate would treat A and B as if they were the same policy, because both have zero deficits. That is a critical and dangerous oversimplification.

These are clearly quite different policies. B is a much bigger private sector and a much smaller federal government than A.

Depending on what the additional government resources are used for in A, and from whom in the private sector they are taken, different people will come to different conclusions about which policy they prefer. For now my point is simply that they are different, yet Washington treats them as if they’re not.

Example 2: A big balanced budget vs. a smaller government financed in part by deficits

Case C: The federal government spends 25% of GDP each year, financed entirely by 25% of GDP in current taxes and with no budget deficit.

Case D: The federal government spends 20% of GDP each year, financed by 18% of GDP in current taxes and 2% budget deficits (= future taxes, with interest).

Note that I equate budget deficits and futures taxes, with interest. A dollar borrowed by the government today represents a claim on future taxpayers. Since the government has to pay to use this money now, future taxpayers also have to pay the interest costs on those deficits, so they will have to pay more than a dollar in future taxes to finance a dollar of today’s government spending.

In my notation, C is (75/25, 25/0) and D is (80/20, 18/2). When comparing C and D, we need to compare not just the zero and the 2, but also the 25 and the 20, or the flip side of this, the 75 and the 80. And to decide which policy we prefer, both allocations matter.

In a traditional deficit-only Washington policy debate, C looks better than D. C is a balanced budget and D has a 2% deficit, therefore imposing costs on future taxpayers. This is a flawed analysis because it is incomplete.

I don’t want to shift costs into the future, so I like the balanced budget of C better than the budget deficits of D. I like the zero better than the two. I also want a bigger private sector and a smaller government, and in this respect 80 of D is far better than the 75 of C. Whether you prefer C or D therefore depends on your preferences on both questions:

On the margin, should more of society’s economic resources be controlled by the federal government, or by private individuals, families, firms, and State & local government?

And how much of our current federal government spending should be financed by current taxpayers, and how much should be shifted to future taxpayers?

Your answer will also probably depend on the uses of the additional government spending, and how and from whom those additional taxes are collected. It should also depend in part on the numbers involved. The relative importance between the size-of-government question and the timing-of-financing question changes a lot when you’re looking at 7 and 10% budget deficits, compared to 2% deficits.

Almost all elected officials of both parties will tell you (and believe) that deficits are bad, that they don’t want to shift financing costs to future taxpayers. Yet they have a political incentive to do so, since they gain the political benefits of promising all sorts of government stuff today, and they have an incentive to avoid the political costs of imposing higher taxes on today’s voting taxpayers.

And while the public debate centers around budget deficits, the first allocation question is harder to resolve. The deep philosophical and partisan split in the American fiscal policy debate is mostly about the relative sizes of the government and the private sector, not about the allocation of the cost of that government between the present and the future.

I draw three conclusions.

Budget deficits are very important. They represent a critical policy choice, the allocation of government financing costs between the present and the future.

A fiscal analysis that focuses only on the deficit is incomplete, because fiscal policy is also about how our elected officials choose to allocate resources between the private and public sectors. There are two value choices, not one, and if we focus on only the budget deficit, we will have incomplete information, get confused, and make bad decisions.

We think we’re fighting about the deficit, when in reality the deep philosophical and political divide in America is mostly about the relative sizes of government versus the private sector.